Japan remains an investment conundrum. At the corporate level there is much to admire: healthy balance sheets improved by rising cashflow, ongoing commitment to restructuring especially in the more domestic sectors where historic overcapacity has affected returns and valuations that appear inexpensive. Ostensibly an attractive cocktail but why then are investors apparently so unenamored? Perhaps the reality is that the ongoing domestic institutional selling, leaving the foreigner as the only buyer, continues to expose the market to more cyclical factors, namely world growth rates and on this score there is cause for concern that corporate profit margins have peaked.

Our primary concern for several months has surrounded earnings forecasts, especially for next year when clearly the benefits of inventory restocking will be removed resulting in a lower base effect and therefore requiring strong sales to post a positive sales number. Analysts have remained very optimistic and have retained target prices that now look attractive given the recent market decline but this still appears overly ambitious as economic growth rates globally are clearly decelerating and the yen remains firm. This matters because investors, based on historical patterns, tend to lose patience rapidly once earnings momentum has peaked.

Given this background and the additional market risk from a resumption of significant equity issues, we are pursuing an investment approach targeting companies with less cyclical earnings streams. Somewhat bizarrely many of these companies trade on valuations well below those of the more depressed cyclicals. This anomaly should be corrected in the coming months but could appear pedestrian near term if risk appetite temporarily recovers. Equally the potential benefits from individual corporate restructurings should be considerable in terms of earnings over the next two years. Given that these opportunities reside in the more domestic sectors, they remain overlooked today. We are further encouraged by a recent meeting with one of our companies. Senior management admitted that not only is their anti takeover poison pill ineffective against a foreign trade buyer but that their leading domestic institutional investors have told them that they cannot be relied upon to thwart any such takeover given the woeful performance of the company in recent years. We believe this is symptomatic. Hence there are enough acorns in the forest to construct a portfolio that is less dependant on more global trends.

Lastly, the political situation remains important in as much as the yen doomsday merchants may have reason to reconsider if the Kan administration does start to overhaul the tax structure. Investors should appreciate that the consequences will be far reaching and will result in a faster pace of consolidation in domestic areas such as retailing as many small operators wither away. Historically it has never been sensible to invest around politics and we are certainly not doing so but we are monitoring events closely.

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